Can the annuities market survive Osborne's bombshell?

Life insurers will face consolidation as the annuities market shrinks

On Wednesday lunchtime, Rodney Cook and his eight-strong management team were sitting in the boardroom in Just Retirement’s head office in the centre of Reigate, in Surrey.

Oblivious to the outside world, the recently floated company’s executive team was discussing current trading and other run-of-the-mill matters.

Just before half past one, an assistant came in to the room, and handed Cook a piece of paper. The Australian-born chief executive couldn’t believe his eyes.

The note, in not so many words, said that the Chancellor had used the Budget to rip apart the UK’s £12bn-a-year annuities market, vowing to give 13m holders of defined contribution (DC) pension schemes the chance to make their own decisions about what to do with their pension pots.

“I didn’t believe it at first,” Cook confessed. But believe it or not, within minutes of George Osborne sitting down, investors across the Square Mile showed what they thought of the surprise plans.

Share prices of life insurers quickly turned red, with specialists such as Cook’s company and Partnership Assurance the worst hit, falling 42.4pc and 55.2pc respectively.

By the end of the day, some £4.4bn had been wiped off the life insurance sector, as shareholders questioned the future of the annuities market following Osborne’s pronouncement.

Analysts, investors and industry specialists alike were quick to point to the seismic shift that would result from the Chancellor’s plans, which he himself called the most radical overhaul of the British pensions industry in more than 90 years.

The changes “represent a significant challenge for everyone involved in helping people secure their retirement income,” warned Otto Thoresen, the director general of the Association of British Insurers, with the biggest challenge of all for those selling individual annuities.

While the initial focus was on some of the bigger names in the sector – including Legal & General and Standard Life – those who will be worse affected will be the smaller, more niche players that have centred their businesses on annuities. Analysts warn that in some instances as much as 90pc of their new business could be wiped out.

For Cook, who runs one of those businesses, the four days that have followed Osborne’s announcement have been unquestionably busy.

After the executive meeting came to what he says was “an abrupt conclusion,” he immediately put in place the company’s much practised – but never used – crisis management process.

Cook and the finance director, Simon Thomas, picked up the telephone to the Prudential Regulation Authority, the company’s regulator, major shareholders, the media, the London Stock Exchange.

The strength of its balance sheet is in part the result of Just Retirement’s £1.1bn stock market float in November.

Private equity firm Permira sold 30.5pc of the business at float, listing the company at 225p a share, and raising £300m of new money to bolster its capital position and drive growth.

The company’s intention to float document boasted that it is the UK’s largest provider of individually underwritten annuities, with a 31pc market share, and the third largest provider in the total annuity market.

But on Friday night, Just Retirement’s shares stood at 140p, having fallen 47.9pc in a week.

“We feel the response has been a little extreme, and markets sometimes react that way,” says Cook, pointing to the fact that Just Retirement’s embedded value – the value of its policies even if it closed to new business tomorrow – is £1bn, against its market value of £759m.

“As we’ve shared with investors over the last couple of days, we have had a strong entry into the defined benefit small scheme market, which is looking good, a potential market of £1bn a year, and the Chancellor made clear he’s not aiming to impact that scheme,” says Cook, whose business specialises in individuals with shorter life expectancy than the norm.

“We’re also one of the largest providers of equity release mortgages, and people releasing equity to enhance incomes in their retirement might see a further increase following the proposals.”

Analysts who cover the sector are less positive, however.

“That business model has pretty much gone,” says Gordon Aitken at RBC Capital Markets. “Those [companies] were dealing with people with shorter life expectancies and if you have a shorter life expectancy the last thing you’re going to do is want to buy an annuity.

“The competitive advantage they had was that they had this data-set which told them how long people with serious conditions and people of a certain type would live.”

But Cook dismisses Aitken’s argument, saying that those with shorter life expectancies are more likely to choose annuities, because of the dangers of living longer should their prognosis improve.

“We do not sell to dying people,” says Cook. “In our case, typical life expectancy is 17 years for enhanced annuities [as opposed to 25 years for average cases] and it is even more critical for those people not to get it wrong.

“We’re seeing this major change as an opportunity and have the skill set to bring about new propositions,” he insists.

This opportunity mantra is one that is repeated by Steve Groves, his opposite number at Partnership Assurance, the other most comparable business listed in London.

“The overall reaction to the proposed changes has been significantly overstated,” says Groves. “There has not been any compulsion in annuities since 2010, and even before that it was only for the very elderly.”

Like Cook, Groves thinks the Chancellor’s insistence that everyone retiring with a DC pension must receive indep-endent advice will lead to increased levels of business.

“All of our business is based on people shopping around. Right now, 50pc don’t shop around. You may see a fall in the overall annuity market, and that’s likely. But for the market that is addressable to me, it will double.”

Such positive thinking has not been reflected in Partnership’s share price, which fell 62pc last week to close at 122.9p on Friday night, less than a third of the price it floated at last June.

As this newspaper reported last week, two of the banks – Bank of America Merrill Lynch (BoA) and Panmure Gordon – have now questioned Partnership’s business model.

BoA, which is Partnership’s broker, told its clients in a research note that the company is “dominated by UK annuities” and that “two thirds of the company’s earnings are dependent” on retail annuities.

Barrie Cornes of Panmure Gordon said it had “very little feel” for the life insurer’s business model as a result of the Chancellor’s Budget, and told clients that on a “conservative basis” it expects sales will fall by around 80pc of previous estimates.Lucinda Hallan, a director in Grant Thornton’s financial services advisory unit, is not surprised, and argues there are a number of consequences of the Chancellor’s “Budget for savers”.

“It will challenge insurance companies to rethink and revalidate the flows of cash and economic value between their different lines of business – which could have some interesting knock-on effects for conversations with regulators,” she says.

As well as surprising companies in the sector, Osborne’s plans also caught the regulator, the Financial Conduct Authority, by surprise.

Just last month, the FCA vowed to shake up the market, which it described as “disorderly”, after it found that three-fifths of consumers buying an annuity failed to switch from the company they had built their pension up with.

A number of companies spoken to in the sector point out that the regulator issued requests just a week ago as part of its planned competition market study, and gave three to four weeks to respond, suggesting it had no knowledge of what the Chancellor had in mind.

Whether the FCA will now postpone its study until the Treasury consultation – which hopes to bring in new tax rules from April 2015 – remains to be seen. But what is clear is that an uncertain playing field could damage companies trying to operate in the sector yet further. Rather than wait, Hallan believes the more astute will act now.

“It will force retirement product providers to move now on a long overdue and radical overhaul of not just annuities but their whole 'at retirement’ offering; rather than waiting to see what comes out of the FCA’s annuity market study in 2015, or tinkering round the edges of their current product set or conduct approach.”

Given the now significant challenges Partnership and Just Retirement face, the IPO pipeline in the annuities space is likely to have closed for some time. Some in the Square Mile have questioned whether Rothesay Life will continue with its initial public offering plans, but sources indicate it is working to 2015 as a float date, and point to the fact that it deals in buying bulk defined benefits rather than dealing with DC annuities.

But one of the obvious outcomes would appear to be consolidation in the industry, as the annuities market shrinks.

Companies like Partnership and Just Retirement “will have to majorly rethink what they are capable of providing,” says Ben Cohen, analyst at Canaccord Genuity. “As mono-line providers, basically their room for manoeuvre is much more limited than the rest of the industry. So even if they have a better product and superior intellectual property, you’ve just taken away 90pc of their business.

“Maybe it doesn’t all go away, but even if some of it is still there it’s still going to be very hard for them to operate profitably I would have thought. I think there is a value in the intellectual property. You might see the IP being sold or the companies being consolidated and the run-off part running down.”

Whatever the future for companies in the life insurance sector, what is clear is that the uncertainty thrown up by the last five minutes of Osborne’s Budget speech will continue to reverberate for some time to come.